What *really* keeps the Fed up at night

The Federal Reserve has a long list of worries about the unexpected consequences of its quantitative easing (QE) program. There’s the risk that all the bond-buying is quietly stoking bubbles in disparate asset classes, and the lingering risk of a future run-up in inflation, and even the political risk of balance sheet losses down the road. But above all, what really keeps Fed policymakers up at night might be their most immediate concern: that investors will overreact when they finally decide to reduce the $85-billion monthly pace of asset purchases.

In perhaps the starkest words yet from someone in Fed Chairman Ben Bernanke’s inner circle, here’s what New York Fed President William Dudley said about this in a speech to the Japan Society in New York on Tuesday:

There is a risk that market participants could overreact to any move in the process of normalization. Indeed, there is some risk that market participants could overreact even before normalization begins, when the pace of purchases is adjusted but the level of accommodation is still increasing month by month. Not only could such responses threaten financial stability, but also they might make it harder to calibrate monetary policy appropriately to the economic situation. We will need to think long and hard about how best to develop policy in a way that enables us to respond flexibly to a changing economic outlook, but in a way that is not disruptive to the economy.

In other words, if the Fed fails to adequately prepare investors for a policy change – however small it may be – it runs the risk of undoing all the progress it has made lowering borrowing costs for Americans. Mike O’Rourke, chief market strategist at JonesTrading, says “markets can become dislocated simply because the Fed is easing at a slower pace.” More from O’Rourke’s note on Dudley’s speech:

Obviously, there are many metaphors that apply. The one that comes to mind is that “When you are trying to get out of a hole, the first rule is stop digging.” The other is that QE has become a monster that can’t be controlled, the “Fed’s Frankenstein.”